Value of Control
When
valuing a firm, you always need to consider the competence and strengths of the
management of the firm. With private firms, where the owner is also the
manager, this consideration carries special weight, since the owner has
absolute control. In contrast, in a publicly traded firm, incompetent
management can often be replaced, if enough stockholders can be convinced that
it is in their best interests to do so.
There
are implications for valuation, if a portion of a private firm is offered for
sale. If that portion provides a controlling interest, i.e, the right to pick
the firmÕs management, it should have a substantially higher value than if it
does not provide this power. Normally, this would mean that 51% of a private
firmÕs equity should trade at a substantial premium over 49%. This applies
whether a firm is being sold to a private entity or a publicly traded firm, and
may arise in an initial public offering. If, for instance, only non-voting
shares or shares with diluted voting rights are offered to investors in the
public offering, they should trade at a discount on shares with full voting
rights.
While
the intuition about the value of control is simple, estimating how much it is
worth is a little more difficult. We will defer a full discussion of the topic
until we get to the chapter on acquisitions, but we will value it as the
difference between two values Š the value of the firm run optimally and the
value of the firm with the incumbent management. For instance, if the value of
a private firm run by incumbent management is $100 million and the value of the
firm run optimally is $150 million, the difference in values between the 51% and
49% shares can be computed.
Value
of controlling interest = 51% of Optimal Value =
0.51* 150 = $ 76.5 million
Value
of non-controlling interest = 49% of Status Quo Value = 0.49 * 100 = $ 49
million
The
additional 2% interest (from 49% to 51%) has a disproportionate effect on value
because of control. This value of control will be greatest for private firms
that are poorly run and will be close to zero for well run firms.
In fact, the same approach can be used to
compute the discount that non-voting shares will trade at, relative to voting
shares in initial public offerings. For instance, assume that the private firm
described above creates 10 million voting shares and offers 70% to the public.
Since the potential for changing management is created by this offering, the
value per share will fall between $10 and $15, depending upon the probability
that is attached to the management change. Thus, if the probability of the
management change is 60%, the value per share will be $13.00.
Value/Shr
Now
assume that this firm had issued 9 million non-voting shares, with management
retaining 1 million voting shares with complete control. In this case, the
non-voting shares will get little or none of the estimated value change from
optimal management. In fact, the values of the two classes can be estimated.
Value:
non-voting share
Value
per voting share =
The
voting shares in this case would trade at an enormous premium over the
non-voting shares, but that is because we have assumed that the probability of
change is still 60%. If the incumbent managers are much more likely to fight a
change in management, this probability will drop and reduce the premium with
it.